It’s now clear that one reason Silicon Valley Bank failed is that it invested in riskier bonds than it could handle. It’s a “textbook case of mismanagement,” Federal Reserve Vice Chair for Supervision Michael Barr told Congress this week. That may be surprising to some people, given that the bonds in question included Treasuries and other government-backed loans, which are widely viewed as among the safest investments. It’s a useful lesson for individual investors about the risks lurking in bond portfolios.
No investment is risk-free, but the closest thing is probably short-term loans to the US government, also known as Treasury bills. That’s because the US government has vast resources to pay back its loans, and investors get their money back quickly. The problem is that it’s hard to make money without taking risk. Since 1926, one-month T-bills have returned 3.2 percent a year, barely above the rate of inflation.
To make money, bond investors must generally take more risk, either by lending to less creditworthy borrowers than the US government, also known as credit risk, or by lending for longer periods, known as term risk or interest-rate risk. While there was little to no credit risk in SVB’s Treasuries and government-backed bonds, these bonds matured over years, not months, packing a meaningful amount of term risk.
The danger with lending for longer is that when interest rates rise, bonds decline in value — and the longer a bond’s term, the greater the decline. It’s simple math: If you own a 10-year Treasury bond yielding 2 percent, which is roughly where yields were a year ago, and yields rise to 3.5 percent, which is where they are now, no one will want your lowly 2 percent bond unless you sell it at a deep discount. That’s precisely the scenario SVB faced when fleeing depositors demanded their cash.
Last year was a master class in what happens to longer-term bonds when interest rates rise. One-month T-bills managed to eke out a return of 1.4 percent in 2022, despite the fact that short-term rates rose more than 4 percentage points. Longer-term Treasuries weren’t as fortunate. Five-year Treasuries lost 9.4 percent when five-year yields rose 2.5 percentage points, and 20-year Treasuries declined 26 percent when 20-year yields rose 2 percentage points.
SVB undoubtedly knows all this, despite numerous claims that the bank’s executives were merely unsuspecting rubes. For one, term risk is bond investing 101. Also, it’s probably no coincidence that SVB’s bond portfolio reportedly had a duration of 3.6 years, which roughly corresponds to a maturity of five years — just the right spot for maximizing expected bond returns relative to term risk. SVB’s mismanagement was more likely knowing and calculated, if ultimately foolish.
The decision to reach for additional yield was particularly brazen given where interest rates were at the time. No one can reliably say where rates will go, as SVB’s implosion demonstrates, but that doesn’t mean all moves are equally likely all the time. Over the past 150 years, the yield on 10-year Treasuries has been as high as 15 percent in 1981 and less than 1 percent in 2020. Needless to say, when interest rates are that close to zero, they have more room to move higher than lower, even if no one knows precisely when.
While term risk is walking-around knowledge for financial types, many investors may not be as familiar. Thankfully, funds that track the broad US bond market, which are popular and ubiquitous in retirement accounts, prevent investors from piling on more term risk than they can afford. SVB was a stark reminder of what happens when you do.
Nir Kaissar is a Bloomberg Opinion columnist covering the markets. Views are personal, and do not represent the stand of this publication.
Credit: Bloomberg
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